Tuesday, April 03, 2007

Tim's email says he is "a bit contrarian" in this one. Agree or disagree, I'm sure he'd like to hear you reactions:

Tim Duy: Fed Still Looking Through the Slowdown – Should You?: The
spate of weak data has been well covered in a variety of places.
David Altig presents some unsettling history,
Jim
Hamilton shares the rational concern over the path of core capital goods
orders, with
Menzie
Chen following up on the implications of the 4Q06 GDP revisions, and
Nouriel Roubini
sticking to the hard-landing story. A pretty grim look at the data; indeed, the
durable goods numbers have unsettled my sleep of late. (Interestingly, I would
have expected a much worse
ISM number given the read on durable goods. We just are not seeing the
strong below-50 plunge consistent with a recession. Yet.)

Still, while acknowledging the downside risks to economic activity, Fed
Chairman Ben Bernanke threw cold water on the idea that a rate cut was imminent
in his
most recent Senate testimony. The Fed continues to stick with its call of
moderate economic growth (note that “moderate” appears to be around 2%, which
suggests, as I have commented before, a not small lowering of potential GDP
estimates) combined with easing inflationary pressures, with the possibility of
greater than anticipated inflation still the predominant risk to that outlook. I
admit to being sympathetic to that view, partly in response to the yield curve,
partly on the mixed nature of the data.

But isn’t that yield curve still inverted? Yes and no. Something interesting
happened recently. If you focus on the spread between the ten year and fed funds
rates rates, you might have missed it. I tend to focus on the ten-two spread,
which has been signaling a period of relatively soft growth and an enhanced risk
of recession. I keep an eye on a simple probit model that uses this month’s
spread to provide an estimate of the probability of recession in 12 months. Note
that is not the probability of recession within the next 12 months. It makes a
difference to me whether the recession is next quarter or four quarters from
now. Also, I stick with a rolling forecast, not fitted values. The model
predicted a period of substantial weakness beginning early 2007, with a 52%
probability of recession in November of this year:

Through the past year, the ten-two spread has never been deep enough to
signal much of a conviction that a recession is a foregone conclusion. The
deepest inversion recently was 15bp in November. In contrast, March 2000 –
exactly 12 months prior to the NBER dated recession – saw a 27bp inversion that
grew to 41bp in April.

Interestingly, the ten-two spread steepened in March in the wake of not
insignificant market volatility. My initial interpretation was that market
participants saw a Fed rate cut as a foregone conclusion at that point. But
throughout March, that expected rate cut was pushed further into the summer,
and
conviction about the cut has waned. Yet, last Friday, the spread stood at a
positive 6bp, which yields a roughly 20% chance of a recession in March 2008 (I
will recalculate when the Fed posts the March average for rates). In other
words, if the steepness in the ten-two spread holds, it is signaling that
economic weakness will be mild, short-lived, and largely dissipated by the first
or second quarter of next year.

Alternatively, my initial interpretation that a rate cut was seen as a sure
thing may be flawed. It may be that a rate cut is not necessary to stave off a
recession. Instead, market participants were just waiting to take out the last
remaining chance that the next Fed move would be a rate hike (although it was
tough to see a hike in the imminent wake of the problems in the subprime
market).

Another alternative is that while the bears are having a field day with some
recent data, market participants have their eyes on the rebound in commodities
such as metals and oil. Moreover, notice the sharp gains in the
Baltic Dry
Freight Index – not exactly a signal of impending recession. And while we
get another read on the labor market this Friday, the fact that initial
unemployment claims stubbornly hover around the 300k mark suggest that the
status quo remains in place. Also,
despite expectations for a collapse in consumer spending, the February PCE
report revealed that real consumption growth is on track for a 3.3% gain in Q1
(I admit to being surprised on the consumption front, as I have been looking for
growth in the 2-3% range). Maybe the March number will turn that around; we did
see weakness in consumer confidence.

Bottom Line: Much of the recent data are weak, no doubt about it. Growth has
slowed, plain and simple. And any optimism I see in the yield curve could be
dissipated with Friday’s labor report. Or, as another Fed watcher once put it,
it could be a case of
Stockholm Syndrome, in which following the Fed forces you to think like
them. But in any event, Bernanke & Co. are sticking to their guns, still looking
through the downturn and downplaying the risk of recession. With so many ready
to call the Fed wrong, it is worth thinking about the possibility that they are
right.

Professor Lutz Kilian of the University of Michigan has an interesting new paper on the historical determinants of crude oil p... [Read More]

Tracked on Wednesday, April 04, 2007 at 05:40 AM

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Tim Duy's Fed Watch: Fed Still Looking Through the Slowdown – Should You?

Tim's email says he is "a bit contrarian" in this one. Agree or disagree, I'm sure he'd like to hear you reactions:

Tim Duy: Fed Still Looking Through the Slowdown – Should You?: The
spate of weak data has been well covered in a variety of places.
David Altig presents some unsettling history,
Jim
Hamilton shares the rational concern over the path of core capital goods
orders, with
Menzie
Chen following up on the implications of the 4Q06 GDP revisions, and
Nouriel Roubini
sticking to the hard-landing story. A pretty grim look at the data; indeed, the
durable goods numbers have unsettled my sleep of late. (Interestingly, I would
have expected a much worse
ISM number given the read on durable goods. We just are not seeing the
strong below-50 plunge consistent with a recession. Yet.)

Still, while acknowledging the downside risks to economic activity, Fed
Chairman Ben Bernanke threw cold water on the idea that a rate cut was imminent
in his
most recent Senate testimony. The Fed continues to stick with its call of
moderate economic growth (note that “moderate” appears to be around 2%, which
suggests, as I have commented before, a not small lowering of potential GDP
estimates) combined with easing inflationary pressures, with the possibility of
greater than anticipated inflation still the predominant risk to that outlook. I
admit to being sympathetic to that view, partly in response to the yield curve,
partly on the mixed nature of the data.

But isn’t that yield curve still inverted? Yes and no. Something interesting
happened recently. If you focus on the spread between the ten year and fed funds
rates rates, you might have missed it. I tend to focus on the ten-two spread,
which has been signaling a period of relatively soft growth and an enhanced risk
of recession. I keep an eye on a simple probit model that uses this month’s
spread to provide an estimate of the probability of recession in 12 months. Note
that is not the probability of recession within the next 12 months. It makes a
difference to me whether the recession is next quarter or four quarters from
now. Also, I stick with a rolling forecast, not fitted values. The model
predicted a period of substantial weakness beginning early 2007, with a 52%
probability of recession in November of this year:

Through the past year, the ten-two spread has never been deep enough to
signal much of a conviction that a recession is a foregone conclusion. The
deepest inversion recently was 15bp in November. In contrast, March 2000 –
exactly 12 months prior to the NBER dated recession – saw a 27bp inversion that
grew to 41bp in April.

Interestingly, the ten-two spread steepened in March in the wake of not
insignificant market volatility. My initial interpretation was that market
participants saw a Fed rate cut as a foregone conclusion at that point. But
throughout March, that expected rate cut was pushed further into the summer,
and
conviction about the cut has waned. Yet, last Friday, the spread stood at a
positive 6bp, which yields a roughly 20% chance of a recession in March 2008 (I
will recalculate when the Fed posts the March average for rates). In other
words, if the steepness in the ten-two spread holds, it is signaling that
economic weakness will be mild, short-lived, and largely dissipated by the first
or second quarter of next year.

Alternatively, my initial interpretation that a rate cut was seen as a sure
thing may be flawed. It may be that a rate cut is not necessary to stave off a
recession. Instead, market participants were just waiting to take out the last
remaining chance that the next Fed move would be a rate hike (although it was
tough to see a hike in the imminent wake of the problems in the subprime
market).

Another alternative is that while the bears are having a field day with some
recent data, market participants have their eyes on the rebound in commodities
such as metals and oil. Moreover, notice the sharp gains in the
Baltic Dry
Freight Index – not exactly a signal of impending recession. And while we
get another read on the labor market this Friday, the fact that initial
unemployment claims stubbornly hover around the 300k mark suggest that the
status quo remains in place. Also,
despite expectations for a collapse in consumer spending, the February PCE
report revealed that real consumption growth is on track for a 3.3% gain in Q1
(I admit to being surprised on the consumption front, as I have been looking for
growth in the 2-3% range). Maybe the March number will turn that around; we did
see weakness in consumer confidence.

Bottom Line: Much of the recent data are weak, no doubt about it. Growth has
slowed, plain and simple. And any optimism I see in the yield curve could be
dissipated with Friday’s labor report. Or, as another Fed watcher once put it,
it could be a case of
Stockholm Syndrome, in which following the Fed forces you to think like
them. But in any event, Bernanke & Co. are sticking to their guns, still looking
through the downturn and downplaying the risk of recession. With so many ready
to call the Fed wrong, it is worth thinking about the possibility that they are
right.